Welcome to the RFF Weekly Policy Commentary, which is meant to provide an easy way to learn about important policy issues related to environmental, natural resource, energy, urban, and public health problems.

The federal government effectively subsidizes various forms of energy production, through favorable tax treatment. How large are these subsidies? What activities do they affect? Is there an economic rationale for these subsidies or should they be scrapped in favor of other polices? These are some of the issues discussed in this week’s commentary by Gilbert Metcalf, a leading expert on the taxation of energy.

Over the summer, commentaries will be posted once every two weeks. In the next commentary, Jonathan Adler will discuss the Endangered Species Act.

According to the Office of Management and Budget in the president's most recent budget submission, the federal government provided over $10 billion in energy-related subsidies through special tax deductions and credits in 2007. But the evidence is mixed on their effectiveness. On the one hand, an increasing share is flowing to non-polluting energy sources, such as production tax credits for renewable electricity generation. On the other, the tax code continues to provide wasteful subsidies, many of which work at cross purposes with desirable energy policy goals; an example here would be the provision of more generous percentage depletion rather than cost depletion for oil and gas drilling. This does nothing to reduce our reliance on oil and natural gas while probably doing little to encourage increased production given current energy prices.

Tax-based energy subsidies are an increasingly important policy tool: in constant dollars, these subsidies have more than tripled between 1999 and 2007. So how do these subsidies work and are we getting our money’s worth? First, we’ll look at the subsidies by fuel type.

Subsidies for renewables currently account for nearly 40 percent of the overall total, with the exemption for ethanol from the federal excise tax on motor vehicle fuels comprising a high percentage. Production tax credits for power generated from renewable sources have been important for encouraging the growing wind market, although they account for less than seven percent of total tax-based subsidies to energy.

Coal accounts for 25 percent of tax-related subsidies and 90 percent of that goes to refined coal. (Refined coal is a fuel produced from coal or high carbon fly ash that is modified to increase its energy content and reduce certain emissions.) Other coal subsidies include, among other things, capital gains tax treatment of royalty payments to owners of land on which coal is mined.

Gilbert E. Metcalfis a professor of economics at Tufts University and a research associate at the National Bureau of Economic Research. His current research focuses on policy evaluation and design in the area of energy and climate change.

Oil and natural gas received 20 percent of the tax-related subsidies in FY 2007. Expensing exploration and development costs and allowing independent producers to use percentage depletion rather than cost depletion account for over three-quarters of this total.

Deductions and credits for installation of energy-efficient appliances, solar panels, and fuel cells, and home improvements or construction totaled $790 million in 2007. This area is small in the grand scheme but has grown rapidly, from three percent of tax subsidies in 1999 to its current eight percent share. (The remaining subsidies are non-fuel specific subsidies for the electricity sector.)

Challenging the Status Quo

Three rationales are often cited to support these subsidies: externalities (in this case, the unreimbursed environmental costs) from energy production and consumption, national security, and market failures in energy conservation markets. While externalities are a significant concern, providing subsidies comes with two important caveats. First, a more efficient approach would be to tax the offending activity rather than subsidize clean alternatives, because subsidies lower the cost of consuming energy and so increase demand. Second, subsidies do not always operate on the right margin. For example, subsidizing the production of electric cars exacerbates rather than alleviates congestion on our nation's roadways.

National security concerns suggest a shift from oil and gas—increasingly being supplied by politically unstable countries—toward renewable energy sources. Subsidies for domestic oil and gas production are often touted as contributing to national security but this ignores the fact that these fuels are priced in world markets. An oil price shock affects the domestic economy whether we are consuming domestic or imported oil. Corn-based ethanol poses an additional problem. By competing with the use of corn as feed, ethanol production drives up agricultural and meat prices, a painful reality that has been well documented in the media. In effect, we are swapping one risk for another, lower energy prices for higher food prices.

The role of market failures in discouraging energy-efficient capital investment cannot be overlooked. Consumers often lack sufficient incentives to change their behavior. Rental housing provides a good example. Tenants who pay directly for their utilities may desire more energy-efficient housing and appliances but landlords may be reluctant to make necessary improvements out of concern that they cannot recoup their incremental investment through higher rents. And tenants who live in buildings that are not individually metered have no direct incentive to save. The appropriate policy response in this situation is to provide investment tax credits for tenants or landlords for such green investments.

We can do better than our current system of subsidies by taking a three-pronged approach. First, the United States should implement a carbon tax that—for political reasons as I discuss elsewhere—is neutral in terms of both revenue and distribution. The tax rate should be raised gradually and predictably over the next several decades as recommended by—among others —William Nordhaus. Second, the United States should double the federal gasoline tax rate, as supported by the research of Ian Parry and Ken Small, and index it for inflation. The increment over the current tax rate of 18.3 cents per gallon should be earmarked for an “Energy Independence Fund” and rebated to households on an equal per-capita basis. Finally, the United States should double its spending on basic energy-related research and development from the current levels of roughly $3.5 billion a year as recommended by Richard Newell in a recent Hamilton Project presentation.

For the United States to move toward a carbon-free future and reduce our reliance on oil will require harnessing market forces and unleashing the creativity of our scientific and engineering community. This kind of retooling could come at less than half the cost of our current system of energy subsidies.

***

Views expressed are those of the author. RFF does not take institutional positions on legislative or policy questions.

To receive the Weekly Policy Commentary by email, or to submit comments and feedback, contactcomments@rff.org